Will centralized derivatives clearing solve our bank credit problems? Those favoring 100% exchange-based trading in general � and centralized clearing in particular � need to address a key flaw in their argument: that the current clearing model can be used to enhance credit risk and financial stability for all over-the-counter trading.

In that current, exchange-based clearing model, exchanges and their clearinghouses intermediate buyers and sellers, facilitate price discovery and enforce daily credit-strengthening collateral requirements on all participants. The exchange model works quite well for standardized futures and option contracts, such as those offered by the Chicago Mercantile Exchange or Chicago Board Options Exchange.

However, the model fails for customized contracts. For example, a customer who needs interest rate protection may purchase an OTC swap from a derivatives dealer and pay a premium to be able to extend the protection if needed. Customized contracts like these cannot be migrated to exchanges that trade standardized contracts until they, too, become standard and widely traded. The reason is simple: The exchange, as a centralized market, cannot provide price discovery for infrequently traded customized derivative contracts, and therefore cannot unilaterally determine the continuous margin requirements necessary to ensure performance on the contracts. Also, as exchanges become more sophisticated, the OTC contracts become more specialized and complex to better meet clients' needs.

OTC counterparties already have credit-enhancing relationships established with each other, wherein they agree on periodic valuations and exchange collateral or extend credit based on their valuation assessments. In most cases, they agree on value. In other cases, counterparties have established methodologies to come to agreement on collateral even if they do not perfectly agree on value. The only problem is that they do not disclose their credit limits or collateral flows, preventing regulators from detecting systemic risks affecting large numbers of banks simultaneously.

This observation suggests a natural and truly universal clearing system, which we may call centralized collateral, not centralized clearing. Centralized collateral allows all trade counterparties, whether OTC or exchanges, to determine their own relative valuations.

Collateral in Custody

Centralized collateral requires all counterparties to be bound by rules for collateral dispute resolution and to use a centralized authority only for the purpose of monitoring collateral and reassigning ownership of the collateral based on changes in market valuations. Actual collateral is held by each counterparty's respective custody agent. This allows all trades to be eligible for centralized collateral reassignment without the need to centralize all clearing functions. In particular, no centralized price discovery is needed. There is also no need to register every trade, and indeed, a registry of complex trades serves no public good if no one outside the counterparties involved knows how to value them.

Here is an example. Counterparties A and B trade exotic interest rate derivatives with each other. They both trade Eurodollar futures with exchange C to hedge imperfectly against changing interest rates � imperfectly because the exchange's standardized contracts do not perfectly match the complex exposures created by A and B. Counterparty A uses custodian X, while B uses custodian Y to hold collateral.

The central collateral authority ensures that A, B and C all have sufficient collateral in their respective repositories, but reassigns ownership claims to the collateral based on changes in interest rates and, therefore, market prices. Counterparties A and B negotiate their own OTC valuations, and exchange C determines the valuations of the futures. The exchange participates in the collateral clearing system like any other OTC counterpart, the only difference being that the exchange does not negotiate its daily market settlements. Cash settlements occur in the usual fashion, reducing collateral pledge requirements.

By monitoring gross collateral flows in the centralized collateral system, Congress or its designated regulator can detect systemic risk without knowledge of every OTC contract. If a large number of banks are suffering collateral losses at the same time, the regulator can easily see the situation developing early and start to take steps towards correcting the problem. The regulator should not care about all the contracts between all counterparties, but rather keep tabs on the daily winners and losers to detect system-wide patterns in losses.

The major casualties of the credit crisis � American International Group, Bear Stearns, and Lehman Brothers � all had secret and unilaterally enforced collateral requirements and were unable to meet those unexpected requirements. A centralized collateral function could dramatically reduce such risks by making collateral transparent and efficient while keeping trades confidential. A centralized clearing function could never achieve this goal, since it could never accommodate all trades. And as Murphy's Law would have it, most of the risk is in the complex trades that will never be able to be cleared centrally.

Finally, on our long road to stabilizing credit through better trading mechanisms, we may well decide to establish a centralized exchange for standardized credit default swaps contracts. This serves the public interest as it hurts some derivative dealers, but a CDS exchange does not solve the underlying credit problems. Centralized collateral solves the underlying problems while centralized clearing of all trades does not.

David Shimko is a former banker and risk consultant, now CRO at NewOak Capital and teaching finance at New York University. He is also joint founder of the independent risk management boutique, Winhall LLC.

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Will centralized derivatives clearing solve our bank credit problems? Those favoring 100% exchange-based trading in general � and centralized clearing in particular � need to address a key flaw in their argument: that the current clearing model can be used to enhance credit risk and financial stability for all over-the-counter trading.

In that current, exchange-based clearing model, exchanges and their clearinghouses intermediate buyers and sellers, facilitate price discovery and enforce daily credit-strengthening collateral requirements on all participants. The exchange model works quite well for standardized futures and option contracts, such as those offered by the Chicago Mercantile Exchange or Chicago Board Options Exchange.

However, the model fails for customized contracts. For example, a customer who needs interest rate protection may purchase an OTC swap from a derivatives dealer and pay a premium to be able to extend the protection if needed. Customized contracts like these cannot be migrated to exchanges that trade standardized contracts until they, too, become standard and widely traded. The reason is simple: The exchange, as a centralized market, cannot provide price discovery for infrequently traded customized derivative contracts, and therefore cannot unilaterally determine the continuous margin requirements necessary to ensure performance on the contracts. Also, as exchanges become more sophisticated, the OTC contracts become more specialized and complex to better meet clients' needs.

OTC counterparties already have credit-enhancing relationships established with each other, wherein they agree on periodic valuations and exchange collateral or extend credit based on their valuation assessments. In most cases, they agree on value. In other cases, counterparties have established methodologies to come to agreement on collateral even if they do not perfectly agree on value. The only problem is that they do not disclose their credit limits or collateral flows, preventing regulators from detecting systemic risks affecting large numbers of banks simultaneously.

This observation suggests a natural and truly universal clearing system, which we may call centralized collateral, not centralized clearing. Centralized collateral allows all trade counterparties, whether OTC or exchanges, to determine their own relative valuations.

Collateral in Custody

Centralized collateral requires all counterparties to be bound by rules for collateral dispute resolution and to use a centralized authority only for the purpose of monitoring collateral and reassigning ownership of the collateral based on changes in market valuations. Actual collateral is held by each counterparty's respective custody agent. This allows all trades to be eligible for centralized collateral reassignment without the need to centralize all clearing functions. In particular, no centralized price discovery is needed. There is also no need to register every trade, and indeed, a registry of complex trades serves no public good if no one outside the counterparties involved knows how to value them.

Here is an example. Counterparties A and B trade exotic interest rate derivatives with each other. They both trade Eurodollar futures with exchange C to hedge imperfectly against changing interest rates � imperfectly because the exchange's standardized contracts do not perfectly match the complex exposures created by A and B. Counterparty A uses custodian X, while B uses custodian Y to hold collateral.

The central collateral authority ensures that A, B and C all have sufficient collateral in their respective repositories, but reassigns ownership claims to the collateral based on changes in interest rates and, therefore, market prices. Counterparties A and B negotiate their own OTC valuations, and exchange C determines the valuations of the futures. The exchange participates in the collateral clearing system like any other OTC counterpart, the only difference being that the exchange does not negotiate its daily market settlements. Cash settlements occur in the usual fashion, reducing collateral pledge requirements.

By monitoring gross collateral flows in the centralized collateral system, Congress or its designated regulator can detect systemic risk without knowledge of every OTC contract. If a large number of banks are suffering collateral losses at the same time, the regulator can easily see the situation developing early and start to take steps towards correcting the problem. The regulator should not care about all the contracts between all counterparties, but rather keep tabs on the daily winners and losers to detect system-wide patterns in losses.

The major casualties of the credit crisis � American International Group, Bear Stearns, and Lehman Brothers � all had secret and unilaterally enforced collateral requirements and were unable to meet those unexpected requirements. A centralized collateral function could dramatically reduce such risks by making collateral transparent and efficient while keeping trades confidential. A centralized clearing function could never achieve this goal, since it could never accommodate all trades. And as Murphy's Law would have it, most of the risk is in the complex trades that will never be able to be cleared centrally.

Finally, on our long road to stabilizing credit through better trading mechanisms, we may well decide to establish a centralized exchange for standardized credit default swaps contracts. This serves the public interest as it hurts some derivative dealers, but a CDS exchange does not solve the underlying credit problems. Centralized collateral solves the underlying problems while centralized clearing of all trades does not.

David Shimko is a former banker and risk consultant, now CRO at NewOak Capital and teaching finance at New York University. He is also joint founder of the independent risk management boutique, Winhall LLC.